Nemak S. A. B. de C. V (BMV:NEMAKA) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Nemak, S. A. B. de C. V. (BMV:NEMAKA) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Nemak S. A. B. de C. V

What Is Nemak S. A. B. de C. V's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Nemak S. A. B. de C. V had Mex$43.9b of debt, an increase on Mex$27.8b, over one year. However, because it has a cash reserve of Mex$14.6b, its net debt is less, at about Mex$29.3b.

A Look At Nemak S. A. B. de C. V's Liabilities

Zooming in on the latest balance sheet data, we can see that Nemak S. A. B. de C. V had liabilities of Mex$33.7b due within 12 months and liabilities of Mex$41.2b due beyond that. Offsetting this, it had Mex$14.6b in cash and Mex$10.9b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by Mex$49.3b.

This deficit casts a shadow over the Mex$17.3b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Nemak S. A. B. de C. V would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Nemak S. A. B. de C. V's net debt to EBITDA ratio of 3.8, we think its super-low interest cover of 1.5 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, Nemak S. A. B. de C. V's EBIT was down 63% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Nemak S. A. B. de C. V's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Nemak S. A. B. de C. V produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, Nemak S. A. B. de C. V's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Nemak S. A. B. de C. V's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Nemak S. A. B. de C. V that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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